Rule Maker Portfolio
Rule Makers and the S&P 500

By Zeke Ashton (TMF Centaur)

ZURICH, SWITZERLAND (September 10, 1999) -- Should Foolish investors exclude companies not included in the S&P 500 as Rule Maker candidates? This question came to me as I was examining the recent underperformance of T. Rowe Price (Nasdaq: TROW) compared to the S&P 500, despite our company's strong financial performance. I noticed that alone among our Rule Maker investments, T. Rowe's stock price has not kept up with the company's fine financial results of late. Then, it occurred to me that our outperforming Rule Maker companies are, without exception, members of the S&P 500. T. Rowe Price isn't included in the index.

Does this constitute anecdotal evidence that Rule Maker companies in the index are more likely to produce superior returns than those not included in the S&P 500? Should we consider giving a company a bonus point or two in our Rule Maker Ranker spreadsheet (linked at bottom) to reflect this advantage? Or, maybe exclude companies outside the index from consideration altogether? It's a provocative question, I know, but let's examine the logic of the argument.

The S&P 500 consists of -- surprise! -- 500 of the biggest, most profitable American companies. The folks at Standard & Poor's go to great effort to keep the S&P 500 chock full of only the leading companies in leading industries. They screen potential entrants strictly, and go to great lengths to ensure that the companies chosen for admission are both consistently profitable and relatively stable. This is one reason why you won't find many Internet stocks (exactly one, AOL) or Biotech stocks (only Amgen) in the index.

This makes sense, of course, when you consider that the S&P doesn't want to be turning over the companies in the index every time an Internet stock goes down in flames or a biotech gets pummeled after being denied FDA approval. Standard and Poor's ideally wants companies in the index that are still going to be going strong 10 years from now, without subjecting investors to excess volatility along the way.

An additional consideration for entry is that a candidate company must have sufficient float. Float refers to the amount of stock held by public investors as opposed to company insiders. The standard rule of thumb is that a company has sufficient liquidity if half the shares are available to the public. This knocks out most Internet companies, as well as strong Rule Maker candidate Berkshire Hathaway (NYSE: BRK.A and BRK.B), which has very little float relative to its size.

I see two very strong arguments for favoring a Rule Maker candidate that is in the index over one that is not:

1) Well-chosen Companies

The folks at Standard & Poor's are pretty darn smart. The fabulous returns of the S&P 500 index, coupled with fact that so many mutual funds can't match the index performance, is strong evidence that companies in the index are likely to be of higher quality than those outside of the index. If you are looking for Rule Makers, you're likely to find all the candidates you'll ever need in the S&P 500.

Of course, as new Rule Makers emerge, they will be added to the index as soon as space becomes available. With mergers, acquisitions, and the occasional corporate implosion accounting for as many as 5-10 new additions each year, the index is constantly being infused with the most promising, hard-charging Rule Maker candidates. Fact is, if your favorite Rule Maker company isn't in the index, there is likely a pretty good reason for it.

2) Index Buying Power

The value of having constant new purchases by the growing number of S&P 500 index funds to nudge the share prices of the component stocks higher should not be underestimated as a contributing factor in the S&P's outperformance in the last several years. Vanguard's S&P 500 Index fund alone is $90 billion dollars, and all of that money is invested in the 500 stocks in the S&P. Further, new money is pouring into these companies at a rate of many billions of dollars per month. Index funds are the fastest growing sector of the mutual fund business, and it certainly doesn't hurt your favorite company's stock to have all that buying power behind it.

It is no accident that attempting to predict the newest entry into the index has become a hot topic for Wall Street investors. It is not uncommon for a company to experience a major percentage jump in price upon being added, partly due to all the index funds being obligated to begin purchasing the newly added company's shares. I would argue that all things being equal, a company in the index has a better chance at being a true Rule Maker and producing excellent returns than a company not in the index.

Having made my arguments for the index, let's talk about the Rule Maker holdings. Being a member of the S&P 500 hasn't helped Coca-Cola's (NYSE: KO) stock performance recently, although one could speculate that the stock would have performed even worse had it not been in the index. Other than Big Red, the strong performers in the Rule Maker portfolio are all in the S&P 500: Microsoft, Cisco, AmEx, The Gap, Pfizer, Schering-Plough, and Intel are all members. T. Rowe Price is not, and Yahoo! (Nasdaq: YHOO) is not. Of these two companies, Yahoo! has outperformed the market strongly, while T. Rowe Price has lagged.

Yahoo!, with a market value of $45 billion, is the second largest company by market value not in the index (the largest is $95 billion Berkshire Hathaway). Yahoo! is likely to be the second Internet company to be admitted, though due to its volatility and somewhat limited float, it is unlikely to go in this year. T. Rowe Price is also often noted as a candidate for eventual entry, but it isn't one of the largest 30 companies not already included. (Biogen and Harley-Davidson are the two names that I have heard being most speculated about as far as immediate entry.)

Both Yahoo! and T. Rowe Price are excellent companies, I might add. Excellent enough to be represented here in the Rule Maker portfolio. I would note, however, that both would be more accurately described as Rule Makers-in-training than the genuine article, and this was duly noted in the buy reports of each company. Yahoo! hasn't yet achieved the Rule Maker standard of $1 billion in annual sales, and T. Rowe Price falls short of both the $5 billion market cap target and the $1 billion annual sales target.

Both were added to the portfolio because they are making broad-based progress towards achieving the high quality of the select inner circle, and both have potential for correspondingly high returns. The fact that both companies are not yet included in the S&P 500 is a further indication that these two fine businesses have not yet achieved the status of industry leaders. I am confident that by the time Yahoo! and T. Rowe achieve no-doubt-about-it Rule Maker status, this achievement will have been pre-empted by their admittance into the index.

So, there you have it. Membership in the S&P 500 is a valuable validation of a company's quality, stability, and future prospects, when used in combination with the classic Rule Maker criteria.

What do you think, Fools? Should a company's status vis-�-vis the S&P 500 bear some weight in the selection process? Weigh in with your opinion on the Rule Maker boards.

Related Links:
- Actively Managed Money by Louis Corrigan
- List of the 500 companies in the index
- Interesting Facts about the S&P 500
- Vanguard's Index 500 Fund

Until next time, y'all stay Foolish!